Dollar Bulls Take a Beating

By

Sarah Morgan

December 3, 2011

Some investors got a painful reminder this past week that there are no "sure thing" currency bets.

On Wednesday, the euro jumped 2% against the U.S. dollar in less than an hour after the Federal Reserve and five other central banks reduced the interest rate banks pay to borrow money, a move designed to bolster the global financial system.

ENLARGE

That was enough time for foreign-exchange traders who had bet against the euro to get burned.

Because currency trades use leverage, or borrowed money, to magnify bets, even quick price moves that might seem small to novice traders can amount to big gains or losses.

For example, an individual can control a $100,000 "forex" trade with a margin deposit of just $2,000 by using 50-to-1 leverage, the maximum allowed by regulators for retail traders. In a trade that size, a 1% move in the currency would be worth $1,000.

Wiping Out Accounts

Given those circumstances, Wednesday's 2% spike in the euro could have completely wiped out some investor forex accounts, says Tommy Molloy, head of trading at FX Solutions, a retail foreign-exchange dealer.

A small but growing cohort of retail investors have turned to the fast-moving foreign-currency markets in recent years for the chance to score quick profits. Thanks to new online-trading systems, it's becoming easier for individuals to get in on the forex action.

Today, there are more than a dozen online brokerages that offer trading in the euro and other currencies to retail investors, most of which launched in the past decade.

In currency trades, investors speculate on changes in exchange rates between pairs of currencies. To buy the euro, traders must sell dollars or another currency, and vice versa. All investors need to get started is an Internet connection and a minimum deposit, often about $2,000. Many dealers offer "mini" accounts that can be opened with as little as $50; investors can also test their skills using practice accounts.

With bond yields near historic lows and stock returns still wildly unpredictable, the allure of these overseas bets is growing, experts say. Average daily volume in retail forex trading quadrupled from 2007 to 2010, to $313 billion, according to a report by the Aite Group, a consultant firm. And while retail trades make up only about 8% of the $4 trillion forex market, financial advisers report that more clients are asking about it.

That popularity hasn't brought much success, however—even before the euro's surprise move. Some of the biggest retail forex brokerages disclosed earlier this year that as few as a third of their retail clients made money trading currencies. Critics say individual traders are at a huge disadvantage in the 24-hour currency markets.

Keeping up with the swings has been even tougher lately as the prices of currencies, like those of stocks, have whipsawed. Back in March and April, the euro-dollar exchange rate typically moved less than 1% in any given two-week period. Over the past two months, that range has widened to about 1.45%.

Despite those swings, the euro now trades just under $1.35, compared with about $1.34 at the beginning of the year. "We haven't moved all year, and yet fortunes have been made and lost," Mr. Molloy says.

The number of traders on the wrong side of that bet appears to have jumped just before the euro's move. According to data provided by DailyFX, a forex brokerage firm, the number of clients who were betting the euro would fall jumped 4% early Wednesday, while the number betting the currency would rise plunged 18%. (All told, investors were split evenly between those betting for and against the euro.)

"A lot of people took a big hit because it was a pretty excessive move in a short period of time," says David Song, a currency analyst at DailyFX.

Use Less Leverage

For investors brave enough to bet on the euro and other currencies, financial advisers recommend taking smaller positions and using less leverage. Traders should also take note of recent trading patterns before making a bet.

For example, the euro has been trading between roughly $1.30 and $1.40 for several months, so investors should consider shorting the currency only when it is near the top of that range, says Andrew Busch, a global currency strategist at BMO Capital Markets.

Another tactic: Set up stop-loss orders in a narrower range, says Camilla Sutton, the chief currency strategist at ScotiaBank. A stop-loss order directs a broker to close out a trade at a predetermined price automatically. For example, an investor might set up an order to exit a trade after a one-cent rise in the euro instead of a two-cent rise. "You need to either keep your stops very tight, or you need deep pockets," Ms. Sutton says.

Investors without forex accounts could use a currency exchange-traded fund such as Pro-Shares Ultra Short Euro or Market Vectors Double Short Euro. But experts warn that these ETFs use leverage to track daily currency moves, so they can generate significant losses or gains on seemingly small moves. For example, the Market Vectors fund should rise 2% for every one-cent drop in the price of the euro against the dollar.

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